Tag Archives: Accounting

deferred taxes (II): how they’re important

February 21, 2013 By in Accounting, deferred tax Tags: , , , , , , , Leave a comment

Yesterday I wrote about what deferred taxes are.  Today,

why it matters

1.  The two most important sources of money coming in the door (i.e., cash flow) for companies are net income and depreciation.  Deferred taxes–that is, tax expense that’s shown on the income statement but not actually paid to the tax authorities, are number three.

Most companies succeed in pushing back the tax bill for an extremely long time.  So although deferred taxes aren’t as rock-solid as net or depreciation as a source of cash flow, they can be pretty dependable.  This means that companies in a heavy investment mode (building new buildings, installing new machinery/computers…) have more money in their hands than the income statement shows.   Look at the cash flow statement–the statement of sources and uses of funds–to see what the effect of deferred taxes on cash flow may be.

Mature companies are gradually forced to pay the tax-break piper.  After all, we’re talking about taxes deferred, not forgiven.  So they have less money coming in than the income statement suggests.  Again, check the cash flow statement.

2.  Deferred taxes have a second, even less intuitively obvious, accounting use.  It’s crucial to understand, though, when dealing with “deep value” (read: really junky) companies.

Suppose the company has a pre-tax loss of $1,000,000 on its tax books.  It can typically “carry back” at least part of the loss, meaning it can retroactively apply it to prior years’ income and get a tax refund.  If it can’t, the after-tax loss is $1,000,000.  And the firm can “carry forward” the loss to use as an offset against taxable income in the future.  These loss carryforwards expire if they’re not used within a certain number of years, however. (Relevant information will be found in the tax footnote to the financials.)

Financial reporting treatment is different.  Normally the firm’s accountants will assume that the tax loss carryforwards will be used to offset future taxable income before they expire.  If so, and the firm has a pre-tax $1,000,000 loss on its shareholder books, the accountants will apply in the current statements a deferred tax credit of, say, $350,000.  So the financial reporting loss will not be $1,000,000 but $650,000.

In this case, the financial reporting books understate the loss.

the crucial issue

That’s not the crucial issue, though.  The accounting firm that prepares the company’s books will only allow the deferred tax deduction as long as it believes the firm will be a “going concern”  (read: will avoid bankruptcy) and will generate enough future taxable income to use the loss carryforwards.  If it decides otherwise, it must require that the company reverse some or all of the previously recorded deferred taxes.

The worst about this is, of course, not the change in accounting treatment, but it signals the words dead and duck have begun to dance across the auditors’ minds.

Check out my post on Mike Mayo and Citigroup for a real-life example.

deferred taxes (I): what they are

February 20, 2013 By in deferred tax Tags: , , , , , 2 Comments

Last week I wrote about how publicly traded companies typically maintain three sets of books:  tax books, management control books and financial reporting books.

The two sets we’ll be concerned about today are the financial reporting books and the tax books, the ones that outsiders get to see.

Hang onto your hat and let’s get started!

why deferred taxes?

It’s reasonable to ask whether these two accounting pictures of a company’s financial health exist in parallel universes–one to poor mouth the company in order to minimize taxes, the other to flatter results so that shareholders will be happier than maybe they should be     …or is there something that ties the two sets together?

they connect tax and shareholder records

There are, in fact, two ways in which these sets of books are connected.

First, the IRS doesn’t let a company pick radically different accounting methods for tax books from the ones it uses for shareholder reports.  Inventories–meaning all that FIFO or LIFO stuff–are an example.

In addition, there are deferred taxes.

what they are

The income tax line is the one place that financial accounting standards compel a company to reveal something about the books it keeps for tax authorities.

When the financial accountants work down the income statement, they start with the sales line.  They subtract various costs, like materials, marketing, interest payments…   from revenues as they work their way to net profit.  When they’ve figured out  pre-tax income, they apply the appropriate income tax rate and subtract to get to net income.  They do this country by country, local and national.  

Then they reconcile with the tax books

They do this by dividing the tax figure they’ve arrived at into two components:

–the tax actually paid to the IRS or its equivalent, called cash taxes; and

–the rest, called deferred taxes.  

The deferred tax figure can be positive, meaning the company is sending smaller check(s) to the tax authorities than the total amount of tax shown on the financial reporting books; or it can be negative, meaning the company is paying out more than the total tax charge shown on the shareholder records.

Sounds weird, doesn’t it?  That’s because it is.

But try to get used to the idea.  It can be important.

how deferred taxes come to be

Lots of ways.  But it’s all about timing differences.

for example

The simplest is this:  a company builds a factory that costs $1,000,000, has a useful life of 40 years and has no value after that.  On the shareholder books, the company allocates the factory expense evenly over the 40 years, at the rate of $25,000 a year.  Accountants call this the straight line depreciation method.

On the other hand, the national government may want to encourage companies to build factories of this type.  So it gives them tax breaks by, say, allowing firms to front-load the tax writeoffs.  Maybe it allows a firm to write off $250,000 of the total cost in the first year (lowering otherwise taxable income by that much), $100,000 in the second, and the rest in progressively smaller amounts over the following seven years.  This is an accelerated depreciation method.

Let’s assume this is the only difference between the company’s tax books and its shareholder books.  If so, in year one the tax books will show $225,000 less in pre-tax income than the shareholder books ($250,000 – $25,000), due to the faster timing of the factory writeoff on the former.  Depending on the rate of corporate income tax, the company will pay something like $80,000 less in cash taxes than the financial books show as due.  This amount will be recorded as deferred tax.

where you can see this stuff

Usually not on the income statement.

Two places:  in the tax footnote to the income statement, and in the cash flow statement   …not usually, however, on the income statement itself.

Tomorrow:  why this geeky stuff can be important

 

one company, three sets of accounting records

February 15, 2013 By in cash flow, cash flow/share vs. earnings/share, project accounting, three sets of books Tags: , , , , , , , , , Leave a comment

In almost all countries publicly traded companies maintain three sets of accounting records.  They are:

–tax books,  in which the firm keeps track of the taxable income it generates, and the taxes due on that income, according to the rules of the appropriate tax authority.

Keeping the tax records may also involve a tax planning element.  A company may, for example, decide to recognize profits, to the extent it can, in a low-tax jurisdiction.  Or, as is often the case with US companies, it may decide not to repatriate profits earned abroad, at least partially because they would thereby become subject to a 35% tax.

Tax considerations can also have operational consequences.  For instance, a firm may choose to locate factories or sales offices in low tax jurisdictions over similar high tax alternatives mostly for tax reasons.

–financial reporting books, in which publicly traded firms keep track of profits, and report them to shareholders, according to Generally Accepted Accounting Principles (GAAP).

If the purpose of tax accounting is to yield the smallest amount of taxable income, and thereby the smallest amount of tax, the intent of financial reporting books can be seen as trying to present the same facts in the rosiest possible manner to shareholders.

The main difference between the two accounting systems comes in how long-lived assets are charged as costs against revenue.  Financial accounting rules allow such costs to be spread out evenly over long periods of time.  Tax accounting rules, which may be specifically designed to encourage investment, typically allow the firm to front-load a large chunk of the spending into one or two years.

The end result is that for most publicly traded companies, the net income reported to shareholders is far higher than that reported to the tax authorities.

—management control books, kept according to cost accounting rules.  These are the records that a company’s top executives use to organize and direct the firm’s operations.  They set out company objectives and incentives, and are used to assess how each of its units are performing against corporate goals.  Not all parts of a firm are supposed to make profits.  Some may have the job of making, at the lowest possible cost, high quality components used elsewhere in the company.  A mature division may not have the job of growing itself anymore,  but of generating the largest possible amount of cash.

investment implications

Investors normally don’t get to see either a company’s tax books or its management control books.

Financial reporting books can sometimes give a picture that’s too rosy.  The two main culprits are deferred taxes and capitalized interest.  “Capitalized” interest is usually the interest on construction loans taken out for a project than’s underway but not yet finished.  Even though money is going out the door, under GAAP it’s not shown as a current expense.   I’ll explain deferred taxes next week.

In a very practical sense, you don’t need to understand either one too much (although it might be nice to).  Turn to the company’s cash flow statement in its latest SEC earnings filing.  Are there deferred tax or capitalized interest entries?  Do they add to cash flow or subtract from it?   …by how much?  If the answer is no, or that they add to cash flow, there’s nothing to worry about.  If they subtract–and a lot, on the other hand, there’s a potential problem.

2013–year of the “Great Rotation”?

January 16, 2013 By in "Great Rotation", Constructing a Portfolio, Current Market Thoughts, Portfolio management, Recent Market Action Tags: , , , , , , , , , Leave a comment

The “Great Rotation” is what journalists have begun the call the idea that investors of all stripes–but particularly retail–are starting to reverse the sharp shift in asset allocation away from stocks and into fixed income that they made as the Great Recession unfolded in 2008.

There’s some evidence that a shift of this kind is beginning.  Recent weeks have shown sharp increases in flows into equity mutual funds, although the main winners have been global/international funds and emerging markets funds–not US-only ones.  At the same time, there have been sharp outflows from developed market bonds funds.  At least some of this money has gone into stocks, although most may have been reallocated into emerging markets bond funds.

I have some reservations, though:

–Yes, the flows have been unusually large.  But until we see more data it’s hard to know whether these are beginning-of-the-year adjustments that will disappear come February, or whether they’re a more enduring trend.

–More important for us as equity investors, it’s not clear that shifts like this are good for stock market performance.  Intuitively, you’d think they should be, but historically they’re not.

Fidelity, for example, released a study more than a decade ago about investor experience in one of its flagship funds.  The results were that the fund itself had made, say, a 100% gain over a ten-year period.  The average investor in the fund, in contrast, had a gain of only, say, 30%.  Why the difference?  People were always selling at low points for fund net asset value (when they were afraid) and buying at high points (when they were feeling good and when the fund had already been showing strong returns for  while).

I’d been working for about a year for a load fund organization trying, unsuccessfully to that point, to improve the performance of a chronically underperforming portfolio (it subsequently did really well, and for a long time).  A very successful broker came up to me at a sales meeting and told me he’d just put a large amount of his clients’ money into my fund.  When I thanked him, he asked me if I wanted to know why he’d done this.  With some trepidation, I said yes.  He told me he looked for competent managers whose portfolios were underperforming and who were generally unloved.  His exit signals?   …a sustained period of outperformance, followed by strong inflows of cash.  The clincher for him was if the organization began a sales campaign touting the fund.

Colleagues at other organizations have told me basically the same thing–they found it’s always time to become defensive if they start seeing large cash inflows.

Look at the past four years.  Despite continual cash outflows from the US market, the S&P has more than doubled from the early 2009 lows.

–a rotation out of bonds, in my view, will only start when interest rates begin to rise–and bond investors begin to experience losses. My guess is that this is a least a year off.  During periods like this in the past, stocks have been flat to up.  Rising interest rates are a negative for stocks, too.  But rates can rise only if the economy is healthy enough to be producing increasing corporate profits, which act as a stabilizing influence on equities.

the fiscal cliff: why not just raise income tax rates?

December 13, 2012 By in capital flight/brain drain, economics Tags: , , , , , Leave a comment

There are several arguments–some theoretical, some the fruit of bitter experience–against raising income tax rates beyond a certain level.

To be clear, personally I don’t think they apply in the present argument about how to close the current US annual $1 trillion+ Federal deficit.  After all, the country seemed to run perfectly fine in the 1990s, when rates were higher.   So I don’t see how turning the clock back to the status quo ante can be so bad.  (Following that logic would also imply rolling back the extra healthcare benefits enacted at the same time.)

I suspect that the biggest stumbling block is that patronage politicians know very well how to divide up shares in an ever-expanding economic pie (who wouldn’t?) but are incapable of agreeing on how to apportion mutual sacrifice.  It doesn’t help matters that, in my view, Republicans have an antediluvian economic philosophy and Democrats have none.

Nevertheless, there’s a limit to how high rates can be pushed.

how can higher tax rates be bad?

When rates reach a certain point:

1.  people start to work less.  I had an eccentric uncle (one of my favorites) who quit his brokerage house back-office job (the only position Irish Catholics would be hired for) and supported himself for the rest of his life investing his own portfolio–turning $400 into $1 million+.  Why leave?  …he was so incensed at the income tax he was paying on overtime.  Uncle Harry wasn’t your typical worker.  But if you’re losing, say, 70% of your incremental income to the tax man, what’s the point of doing extra work?

2.  people spend increasing amounts of time on gaming the tax code, diverting economic energy from more productive uses. Behavior can get crazy.  In the UK in the early 1980s, companies were buying suits and renting them to their executives rather than giving pay raises, because the tax on incremental individual income was so high.  If history runs true, the loophole-ridden US tax system would spawn huge amounts of new tax shelters–very profitable for promoters, disastrous for the purchasers.

3.  tax avoidance accelerates.  I was sitting next to the Spanish finance minister at a lunch early in my career.  I naively suggested that his country would have to raise income taxes in order to close a troublesome budget deficit.  The minister looked at me like I had dropped from the moon.  He explained that income tax rates in Spain were already as high as they could go.  Experience showed that pushing them higher resulted in lower tax receipts.  Very many people would begin to hide substantial amounts of their income from official eyes through off-the-books transactions.

4.  people leave the country.  In the US, we can see this behavior on the state level, in the steady migration from high-tax areas like New York, New Jersey or California.  France, which has recently raised the top income tax rate on high earners to 75%, is now seeing the wealthy starting to renounce their French citizenship and move elsewhere in the EU, like the UK or Belgium.